On January 11, 2011, the U.S. Supreme Court issued its opinion in Mayo Foundation for Education and Research, et al. v. U.S. dealing with the question of whether Treasury regulations regarding a FICA tax exception for compensation paid to medical residents were valid. The Court unanimously upheld the Treasury regulations.
Background of Judicial Review of Regulations
There are two “types” of regulations in the context of the Internal Revenue Code: an interpretive regulation which is issued pursuant to the “general” authority of the Treasury to interpret the Code, and a legislative regulation which is authored by the Treasury pursuant to a specific directive in a Code provision. In addition, one of two standards of review generally applies when a court is asked to analyze the validity of an agency regulation. The first is the so-called National Muffler standard which requires a court to determine whether the regulation implements a congressional mandate in a reasonable manner and harmonizes with the plain language of the statute, its origin and its purpose. Under the National Muffler standard, a court would generally view an agency’s interpretation of an ambiguous statute with heightened skepticism when the agency has not been consistent in its interpretation of the statute over time. On the other hand, the Chevron standard gives deference to an agency’s interpretation of an ambiguous statute even if the agency has been inconsistent so long as the regulation is not arbitrary or capricious in substance, or manifestly contrary to the applicable statute. Historically, legislative regulations are analyzed under the more deferential Chevron standard while interpretive regulations have been analyzed under the less deferential National Muffler standard. However, prior to Mayo there was uncertainty as to which standard should apply in the context of an interpretive Treasury regulation because the U.S. Supreme Court has cited both standards in its review of Treasury regulations without specifically setting out which standard of review is applicable.
Background of the Mayo Case
At issue in Mayo was the Treasury’s interpretation of the Code’s exception of certain compensation from FICA tax. Generally, FICA tax does not apply to compensation paid to a student employed by a school, college or university if the student is regularly enrolled and regularly attending classes at the institution. The Treasury’s interpretive regulations provide that an institution is a “school, college, or university” only if its primary function is formal instruction, it has a regular faculty and curriculum, and it has a regularly enrolled student body. Furthermore, the regulations provide that an employee is a “student” only if the services he or she provides are incidental to the course of study and the educational aspect of the relationship predominates over the service aspect. If a person works more than 40 hours per week, the regulations state that the service provider is deemed a full time employee and therefore, the person is not a student and the services provided cannot be incidental to course of study.
The Mayo Foundation offered residency programs for medical school graduates. While the Mayo residents were required to take classes, the residents spent 50 to 80 hours per week caring for patients. The residents were paid annual stipends of $40,000 along with malpractice insurance, paid vacation time and health insurance. The U.S. District Court in Minnesota issued an opinion in 2007 which invalidated the Treasury’s interpretive regulations by ruling that the regulations were invalid under both the National Muffler and Chevron standards. The court concluded that the I.R.S. had inconsistently interpreted the Code and that the regulations were also arbitrary and capricious. In 2009, the Court of Appeals for the Eighth Circuit reversed the District Court and determined that the regulations constituted a valid interpretation of the Code under the Chevron standard. The U.S. Supreme Court therefore agreed to review the Eighth Circuit’s decision.
The Mayo Decision
In a unanimous decision, the U.S. Supreme Court applied the Chevron standard in reviewing the Treasury regulations. The Court specifically acknowledged that in prior opinions it had stated that less deference should be applied to interpretive Treasury regulations adopted pursuant to a general, rather than specific, grant of congressional authority. Nevertheless, the Court indicated that the administrative landscape had changed significantly since its earlier opinions and therefore, Chevron deference is appropriate when it appears that Congress delegated the authority to the agency generally to make rules carrying the force of law. The Court held that the specific Treasury regulations dealing with the FICA tax exception for students were validly issued in the exercise of the agency’s general authority. Thus, the Court held that judicial review of a regulation does not depend upon whether Congress’s delegation of authority to an agency was specific or general. Ultimately, the court held that the regulations were not arbitrary, capricious or manifestly contrary to the Code.
This decision impacts not only the imposition of FICA tax on compensation paid to medical residents, but this decision will likely make it much more difficult for taxpayers to challenge regulations adopted by the Treasury in the future.